In this blog post, we are discussing the last component of a financial statement: the statement of cash flow. As its name suggests, a statement of cash flow reports the cash inflows and outflows of a business over a period of time. Statement of cash flows, income statement, and statement of equity make up a complete record of financial activities over the same period of time, and this record is the change in balance sheets between two different points in time.
So, what can we tell from a statement of cash flows? How might that information help us?
Statement of cash flows has a quite simple format compared to other financial statement. Every record falls under three major categories:cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. At the bottom of the statement there’s the sum of all the records in those categories, net increase in cash. (Could be a negative.) Then there’s the cash balance at the beginning of the recorded time period and the cash balance at the end of recorded the time period. The difference between the two should be the net increase in cash.
Cash flows from operating activities stand for all the cash inflows and outflows directly involved in the production and sales of a business. We start the calculation with revenue, which in the above example is “cash received form customers. That is the total cash inflow of a business’s operating activities. Then we subtract production cost, employee wages, tax, and other expenditures related to the production and sales from the revenue. The difference yields net cash provided by operating activities, which should also be equivalent to gross profit in the income statement. In the above example of Emerson Corporation, it yielded a revenue of 3,000,000 dollars in the recorded year. It spent 2,200,000 dollars in cost, and that creates a net cash from operating activities of 800,000 dollars.
Cash flows form investing activities stand for the cash changes in the purchase and sale of a company’s capital: such as land, factories, equipments, or even intellectual properties. For the example Emerson Corporation in the recorded year, it gained 750,000 dollars from selling some of the land it owns, and lost 150,000 dollars from purchasing equipments. The difference, which is 600,000 dollars in the example, is the net cash provided by investing activities. Very straight forward.
Cash flows from financing activities records the cash changes in borrowing and lending money and the issuance (or repurchases) of stocks of a company. Under cash flows from financing activities, the cash inflows are usually revenue from issuing stocks, and the cash outflows are usually repayment of loans, payment of dividends to its shareholders, or repurchases of stocks. In the example of Emerson Corporation, there’s 80,000 dollars revenue from issuing stocks, and a sum of 950,000 dollars in expenditure of dividends and repayment of long-term loans. The difference of net expenditure and net gain give net cash flow from financial activities, which in the example is negative 870,000 dollars. It means that Emerson Corporation lost 870,000 dollars from financial activities in the recorded year.
We add up the net cash changes from all three activities and we get the net cash increase of a company over a marked period. For Emerson Corporation, the sum adds up to 530,000 dollars. At the beginning of the marked period, Emerson had 170,000 dollars, and at the end of the year, it had 700,000 dollars. The difference is congruent to the net increase in cash.
Now, from the statement of cash flows we can tell a lot about a companies strategic plans for the future. From the cash flows from investing activities, we can see how hard a company is investing in itself. If a company is purchasing lots of equipments or plants for itself, it usually means that the company is currently under a rapid expansion stage of its growth. For value stock holders, it could be very good news if the performance of the company’s business can support the scale of expansion. For Emerson Corporation, it had a huge gain in its investing activities from selling its land. Without anymore context, the sale of land can be interpreted very differently. Maybe the business is in decline, and the board wants to make as much value of its current assets as it can. However, we see from “cash flows from operating activities” that the company has a decent gross profit, and a fair profit/revenue ratio. It doesn’t look like the performance of the company is in decline. The sale of land could also mean that the business is under transformation. Maybe it is looking for a new more profitable market, and it will be much more efficient to move its plants and production process elsewhere. Combined with information of the company’s marketing plans, these supposition derived from statement of cash flows can be very powerful helpers for one’s investment decisions.
Negative numbers in statement of cash flows aren’t always a bad indicator for a business. For example, Emerson Corporation has a great negative sum of net cash from financing activities that also greatly affects the net cash increase. However, if we look at the specific entries in the categories, we find out that the major cost came from repayment of long-term loans. The more expenditure in the repayment of loans, the more equity a company owns. The more equity a company owns the more value there is to the share of the company that investors hold. The 900,000 dollars of negative increase is, in this case, actually a good thing to investors.
Finally, net increase in cash is usually a very good reflection of a company’s performance over the marked period and can say a lot about what the company can do in the future. Cash has the greatest liquidity among all assets, which means the company has lots of freedom to its usage. For Emerson Corporation, it has a 530,000-dollar increase in cash over the marked period, which is more than a 300% increase. Emerson is holding much more cash than before and it is a major opportunities for Emerson to transform its business because of the freedom it has with its capital. The transformation whether good or bad is a big tell for investors that some changes are coming. Be cautious with your investments.